But all governments must recognise that they themselves potentially pose the
biggest threat. There is a danger that, through vacillation and confusion,
they will create policy risk that undermines the confidence of the companies
largely responsible for delivering the transition to low-carbon economic
growth and development. ...

Some politicians will still seek to deny the science and downplay the risks.
Many of them have vested financial interests in protecting the status quo,
or ideological beliefs that mean they cannot acknowledge the logic of
correcting market failures ... to strengthen the role of markets... Although
they are small in number, they still have the power to create confusion and
slow action.

But everywhere evidence is emerging of opportunities afforded by new energy
sources that are more efficient and less polluting. No investor should fail
to be impressed by how rapidly the costs of solar photovoltaics and other
technologies are falling. ...

The new IPCC report should now convince all world leaders to accelerate
their efforts to tackle climate change and create a safer and more
prosperous world.

Given the (intentionally created) political climate surrounding attempts to address this problem, it's hard for me to imagine anything of significance happening anytime soon.

In Europe, we have the bizarre story of both George Osborne ... and Olli
Rehn ... claiming success for their austerity policies based on one quarter
of growth. ...

In the United States, we were treated to the
Wall Street Journal (WSJ) boasting of the success of the 2011 debt
ceiling agreement on the eve of another standoff on the budget and the debt
ceiling. The measure of success in this case appears to be that the
sequester budget cuts put in place by the agreement are still in place and
that the economy has not collapsed as a result. ...

First, it is worth noting that many of the disaster warnings about the
sequester from President Obama and the Democrats were grossly exaggerated.
...

However, this doesn't mean that the sequester is harmless. ...

We ... know the sequester will give us deteriorating government services,
higher unemployment, and slower economic growth. That's the track record
which prompts the Wall Street Journal's boasts – and the GOP's misguided
actions – in favor of even more austerity.

But if the real goal of the GOP is to reduce the size of government, particularly social insurance, and if the fact that it comes at the expense of the most vulnerable in society is not that great of a concern, then it's not at all clear that austerity has been a failure (and Republicans have also managed to undermine the public's faith in the ability of government to solve important problems whch could also be added to the success side of the ledger). The GOP often argues in terms of jobs and growth, but it is usually cover for a broader agenda.

O.K., a temporary government shutdown ... wouldn’t be the end of the world.
But a U.S. government default, which will happen unless Congress raises the
debt ceiling soon, might cause financial catastrophe. Unfortunately, many
Republicans either don’t understand this or don’t care. ...

Today we have a weak economy, with falling government spending
one main cause of that weakness. A shutdown would amount to a further
economic hit...

Still, a government shutdown looks benign compared with the possibility that
Congress might refuse to raise the debt ceiling.

First of all, hitting the ceiling would force a
huge,
immediate spending cut, almost surely pushing America back into
recession. Beyond that, failure to raise the ceiling would mean missed
payments on existing U.S. government debt. And that might have terrifying
consequences. ...

No sane political system would run this kind of risk. But we don’t have a
sane political system; we have a system in which a substantial number of
Republicans believe that they can force President Obama to cancel health
reform by threatening a government shutdown, a debt default, or both, and in
which Republican leaders who know better are afraid to level with the
party’s delusional wing. ...

Meanwhile,... reasonable people know that Mr. Obama can’t and won’t let
himself be blackmailed in this way... After all, once he starts making
concessions to people who threaten to blow up the world economy unless they
get what they want, he might as well tear up the Constitution. But
Republican radicals — and
even some leaders — still insist that Mr. Obama will cave in to their
demands.

So how does this end? ... Ironically, considering who got us into our
economic mess, the most plausible answer is that Wall Street will come to
the rescue — that the big money will tell Republican leaders that they have
to put an end to the nonsense.

But what if even the plutocrats lack the power to rein in the radicals? In
that case, Mr. Obama will either let default happen or find some way of
defying the blackmailers, trading a financial crisis for a constitutional
crisis.

This all sounds crazy, because it is. But the craziness, ultimately, resides
not in the situation but in the minds of our politicians and the people who
vote for them. Default is not in our stars, but in ourselves.

Sunday, September 29, 2013

Creating a New Responsibility: Between the political posturing in
Washington, and the excellent nuts-and-bolts reporting of the major news
organizations, it is easy to lose sight of what is about happen on Tuesday.

When the Affordable Care Act takes effect, October 1, requiring
most US citizens to obtain health insurance one way or another or pay a tax
penalty for going without, a new obligation of citizenship will have been
recognized by law.

The responsibility to take care of oneself will have been joined, however
loosely, to the long-established right to emergency medical care.

Something like 25 million citizens, more than half of those who are currently
uninsured, will enter into a relationship with a medical practice within the
next few years. They’ll join more than 250 million Americans who
are currently insured in the biggest undertaking to improve public
health since the days of city sanitation and the war on communicable disease
more than a century ago.

In many states, collective well-being will begin to improve almost
immediately (the initial enrollment period extends through the end of March). In
other states, especially those in the Southeast, where Republican governors have
dug in against implementation of the law, a more complicated political game will
play on. Everywhere, changes within the enormous health care sector, already
underway, will gather momentum.

No wonder the fuss is so great...

On Tuesday the Affordable Care Act goes into effect. It was passed by the
Congress and upheld by the Supreme Court. The White House holds all the
cards. The Defunders, the operating arm of the Tea Party in Congress, are
certain to lose if the president remains firm. He should simply state: you
don’t negotiate with terrorists.

As if to underscore the point, Senator Tom Coburn (R-Oklahoma), a veteran of
the
government shutdowns of 1995-96,
toldPolitico last week that if If the Republicans succeed in
shutting down the government Tuesday, “they’ll fold like hotcakes” after a week
or two, when constituents begin to complain about the lack of service. “You do
not take a hostage you are not going to for sure shoot. And we will not for sure
shoot this hostage.”

And in the longer term? My guess is that Tea Party dissidents will lose
ground in the midterm elections next year; that the GOP will split in the 2016
campaign and that a Democrat will be elected president; that in 2018 the Tea
Party will further fade. And by 2020, the Republican governors who are
successful in implementing the Affordable Health Care Act will be running for
president, strongly, on the strength of their records.

Under the weather today, so I'll hand the microphone over to Rajiv Sethi:

Information, Beliefs, and Trading: Even the most casual observer of
financial markets cannot fail to be impressed by the speed with which prices
respond to new information. Markets may
overreact at times but
they seldom fail to react at all, and the time lag between the emergence of
information and an adjustment in price is extremely short in the case of
liquid securities such as common stock.

Since all price movements arise from orders placed and executed, prices can
respond to news only if there exist individuals in the economy who are alert
to the arrival of new information and are willing to adjust positions on
this basis. But this raises the question of how such "information traders"
are able to find willing counterparties. After all, who in their right mind
wants to trade with an individual having superior information?

This kind of reasoning, when pushed to its logical limits, leads to some
paradoxical conclusions. As shown by Aumann, two individuals who are
commonly known to be rational, and who share a common prior belief about the
likelihood of an event, cannot agree
to disagree no matter how different their private information might be.
That is, they can disagree only if this disagreement is itself not common
knowledge. But the willingness of two risk-averse parties to enter opposite
sides of a bet requires them to agree to disagree, and hence trade
between risk-averse individuals with common priors is impossible if
they are commonly known to be rational.

This may sound like an obscure and irrelevant result, since we see an
enormous amount of trading in asset markets, but I find it immensely
clarifying. It means that in thinking about trading we have to allow for
either departures from (common knowledge of) rationality, or we have to drop
the common prior hypothesis. And these two directions lead to different
models of trading, with different and testable empirical predictions.

The first approach, which maintains the common prior assumption but allows
for traders with information-insensitive asset demands, was developed in a
hugely influential paper
by Albert Kyle. Such "noise traders" need not be viewed as entirely
irrational; they may simply have urgent liquidity needs that require them to
enter or exit positions regardless of price. Kyle showed that the presence
of such traders induces market makers operating under competitive conditions
to post bid and ask prices that could be accepted by any counterparty,
including information traders. From this perspective, prices come to reflect
information because informed parties trade with uninformed market makers,
who compensate for losses on these trades with profits made in transactions
with noise traders.

An alternative approach, which does not require the presence of noise
traders at all but drops the common prior assumption, can be traced to a
wonderful (and even earlier) paper by
Harrison and Kreps. Here all traders have the same information at each point
in time, but disagree about its implications for the value of securities.
Trade occurs as new information arrives because individuals interpret this
information differently. (Formally, they have heterogeneous priors and can
therefore disagree even if their posterior beliefs are commonly known.) From
this perspective prices respond to news because of heterogeneous
interpretations of public information.

Since these two approaches imply very different distributions of trading
strategies, they are empirically distinguishable in principle. But
identifying strategies from a sequence of trades is not an easy task. At a
minimum, one needs transaction level data in which each trade is linked to a
buyer and seller account, so that the evolution of individual portfolios can
be tracked over time. From these portfolio adjustments one might hope to
deduce the distribution of strategies in the trading population.

In a
paper that I have
discussed previously on this blog, Kirilenko, Kyle, Samadi and Tuzun
have used transaction level data from the S&P 500 E-Mini futures market to
partition accounts into a small set of groups, thus mapping out an
"ecosystem'' in which different categories of traders "occupy quite
distinct, albeit overlapping, positions.'' Their concern was primarily with
the behavior of high frequency traders both before and during the flash
crash of May 6, 2010, especially in relation to liquidity provision. They do
not explore the question of how prices come to reflect information, but in
principle their data would allow them to do so.

I have recently
posted the
first draft a paper, written jointly with David Rothschild, that looks at
transaction level data from a very different source: Intrade's prediction
market for the 2012 US presidential election. Anyone who followed this
market over the course of the election cycle will know that prices were
highly responsive to information, adjusting almost instantaneously to news.
Our main goal in the paper was to map out an ecology of trading strategies
and thereby gain some understanding of the process by means of which
information comes to be reflected in prices. (We also wanted to evaluate claims
made at the time of the election that a large trader was attempting to
manipulate prices, but that's a topic for another post.)

The data are extremely rich: for each transaction over the two week period
immediately preceding the election, we know the price, quantity, time of
trade, and aggressor side. Most importantly, we have unique identifiers for
the buyer and seller accounts, which allows us to trace the evolution of
trader portfolios and profits. No identities can be deduced from this data,
but it is possible to make inferences about strategies from the pattern of
trades.

We focus on contracts referencing the two major party candidates, Obama and
Romney. These contracts are structured as binary options, paying $10 if the
referenced candidate wins the election and nothing otherwise. The data
allows us to compute volume, transactions, aggression, holding duration,
directional exposure, margin, and profit for each account. Using this, we
are able to group traders into five categories, each associated with a
distinct trading strategy.

During our observational window there were about 84,000 separate
transactions involving 3.5 million contracts and over 3,200 unique accounts.
The single largest trader accumulated a net long Romney position of 1.2
million contracts (in part by shorting Obama contracts) and did this by
engaging in about 13,000 distinct trades for a total loss in two weeks of
about 4 million dollars. But this was not the most frequent trader: a
different account was responsible for almost 34,000 transactions, which were
clearly implemented algorithmically.

One of our most striking findings is that 86% of traders, accounting for 52%
of volume, never change the direction of their exposure even once. A further
25% of volume comes from 8% of traders who are strongly biased in one
direction or the other. A handful of arbitrageurs account for another 14% of
volume, leaving just 6% of accounts and 8% of volume associated with
individuals who are unbiased in the sense that they are willing to take
directional positions on either side of the market. This suggests to us that
information finds its way into prices largely through the activities of
traders who are biased in one direction or another, and differ with respect
to their interpretations of public information rather than their
differential access to private information.

Prediction markets have historically generated forecasts that compete
very effectively with those of the best pollsters. But if most traders
never change the direction of their exposure, how does information come to
be reflected in prices? We argue that this occurs through something
resembling the following process. Imagine a population of traders
partitioned into two groups, one of which is predisposed to believe in an
Obama victory while the other is predisposed to believe the opposite.
Suppose that the first group has a net long position in the Obama contract
while the second is short, and news arrives that suggests a decline in
Obama's odds of victory (think of the first debate). Both groups revise
their beliefs in response to the new information, but to different degrees.
The latter group considers the news to be seriously damaging while the
former thinks it isn't quite so bad. Initially both groups wish to sell, so
the price drops quickly with very little trade since there are few buyers.
But once the price falls far enough, the former group is now willing to buy,
thus expanding their long position, while the latter group increases their
short exposure. The result is that one group of traders ends up as net
buyers of the Obama contract even when the news is bad for the incumbent,
while the other ends up increasing short exposure even when the news is
good. Prices respond to information, and move in the manner that one would
predict, without any individual trader switching direction.

This is a very special market, to be sure, more closely related to sports
betting than to stock trading. But it does not seem implausible to us that
similar patterns of directional exposure may also be found in more
traditional and economically important asset markets. Especially in the case
of consumer durables, attachment to products and the companies that make
them is widespread. It would not be surprising if one were to find Apple or
Samsung partisans among investors, just as one finds them among consumers.
In this case one would expect to find a set of traders who increase their
long positions in Apple even in the face of bad news for the company because
they believe that the price has declined more than is warranted by the news.
Whether or not such patterns exist is an empirical question that can only be
settled with a transaction level analysis of trading data.

If there's a message in all this, it is that markets aggregate not just
information, but also fundamentally irreconcilable perspectives. Prices, as
John Kay
puts it, "are the product of a clash between competing narratives about
the world." Some of the volatility that one observes in asset markets arises
from changes in perspectives, which can happen independently of the arrival
of information. This is why substantial "corrections" can
occur even
in the absence of significant news, and why stock prices
appear to "move too much
to be justified by subsequent changes in dividends." What makes markets
appear
invincible is not the perfect aggregation of information that is
sometimes attributed to them, but the sheer unpredictability of persuasion,
exhortation, and social influence that can give rise to major shifts in the
distribution of narratives.

Is it possible that we are lapsing into what I call a bubble mentality — a
self-reinforcing cycle of popular belief that prices can only go higher? ...

People who are now inclined to buy a home are most often just thinking that
we are gradually recovering from a recession and that this is a good time to
buy. The mental framing still seems to be about economic recovery and the
likelihood that interest rates will rise. People mostly don’t seem to be
prompted by the anticipation of another housing boom.

That’s the thinking at the moment. But whether these attitudes mutate into a
national epidemic of bubble thinking — one big enough to outweigh higher
mortgage rates, fiscal austerity in Congress and other factors — remains to
be seen.

New York Federal Reserve President William DudleyEvent: Speech, interviewTaper?: Sets a high bar for taper, seeing insufficient
evidence that the recovery is either sufficient or sustainable. Notable quote: "Although the neutral rate should gradually
normalize over the long-run as economic fundamentals continue to improve and
headwinds abate, this process will likely take many years. In the
meantime, the federal funds rate level consistent with the Committee’s
objectives of maximum sustainable employment in the context of price
stability will likely be well below the long-run level."

St. Louis Federal Reserve President James BullardEvent:SpeechTaper?: September was a close call, October possibleNotable
quote: “We said it was data dependent,” Bullard told reporters
after a speech in New York. “It turned out it was data dependent. It
enhanced our credibility in the sense that it showed we really are paying
attention to the data.”

Federal Reserve Governor Jeremy SteinEvent: SpeechTaper?: September close, but he supported holding back.
Likely would not oppose taper.Notable Quote: "...my personal preference would be to make
future step-downs a completely deterministic function of a labor market
indicator, such as the unemployment rate or cumulative payroll growth over
some period. For example, one could cut monthly purchases by a set amount
for each further 10 basis point decline in the unemployment rate."

Minneapolis Federal Reserve President Narayana KocherlakotaEvent:SpeechTaper?: Believes the Fed should do more,
not necessarily more QE. Notable Quote: "Doing whatever it takes in the next few
years will mean something different. It will mean that the FOMC is willing
to continue to use the unconventional monetary policy tools that it has
employed in the past few years. Indeed, it will mean that the FOMC is
willing to use any of its congressionally authorized tools to
achieve the goal of higher employment, no matter how unconventional those
tools might be." Shades of Draghi, no?

Dallas Federal Reserve President Richard FisherEvent:SpeechTaper?: Hell, yes, that's how we do it in Texas.Notable Quote: "Here is a direct quote from the summation
of my intervention at the table during the policy “go round” when Chairman
[Ben] Bernanke called on me to speak on whether or not to taper: “Doing
nothing at this meeting would increase uncertainty about the future conduct
of policy and call the credibility of our communications into question.” I
believe that is exactly what has occurred, though I take no pleasure in
saying so."

Kansas City Federal Reserve President Esther GeorgeEvent:
SpeechTaper?: If you need to ask, you aren't paying attention.Notable Quote: "Delaying action not only allows potential
costs to grow, it also has the potential to threaten the credibility and the
predictability of future monetary policy actions. Policy moves that surprise
the market often result in additional volatility. And by deciding that it
needs to await further data, the Committee is suggesting its desire to be
“data dependent” involves putting more emphasis on the most recent data
points, which can be volatile and subject to revision,rather than on its own
medium-term view of the economy."

Chicago Federal Reserve President Charles EvansEvent:Speech
(FYI: Great slides!)Taper?: Close call, could still be this year.Notable
Quote: The Fed's current monetary policy "admits the
possibility of overshooting our inflation objectives," Evans said..."We
could even do this as long as inflation was below 3 pct because I think
symmetry around the inflation target is incredibly important," he added.

Richmond Federal Reserve President Jeffery LackerEvent:SpeechTaper?:
Yes, never a supporter in the first place.Notable Quote: "Yielding to the temptation to implicitly
renege by reworking decision criteria or citing unforeseen economic
developments may have short-term appeal, but widely perceived discrepancies
between actual and foreshadowed behavior will inevitably erode the faith
people place in future central bank statements."

Atlanta Federal Reserve President Dennis LockhartEvent:
Speech (Topic is productivity, indirect reference to monetary policy),
interviewTaper?: Close call in September, probably not October, but
Lockhart will fall in line with whatever is the FOMC concensus. Notable Quote: “In the short time between now and the
October meeting, I don’t think there will be an accumulation of enough
evidence to dramatically change the picture” about where the economy now
stands, Mr. Lockhart said.

Bottom Line: Is that clear yet? My attempt to summarize:

There is broad support/willingness to start the tapering process as soon
as the data allows. In general, even the doves believe that it is the
stock, not flow, that matters, and at this point a small taper will have
little impact on the stock. Earliest timing is December. If the government
shuts down, they might not even have an employment report for the October
meeting. That's going to open up a whole Friday on everyone's calendar.

Financial stability would add to the case for tapering. The Fed does
not want tapering to be a signal about interest rate policy. If they
believe taper talk has only raised the term premium, but is not affecting
the expected path of policy, they will be more likely to taper. Read the
Stein speech.

You see constant reminders that tapering is not tightening, and that
more accommodation could be provided via forward guidance. This is the
direction the Fed wants to go.

There is some push to include an even looser inflation threshold than
the current 2.5%. I think this is limited to Kocherlakota and Evans. Maybe
Yellen, but we will need to wait until her confirmation before we here from
her again.

I think we will see more effort to convince us that the commitment to a
long-term low-rate environment is credible. I think this is difficult if
they continue to place numeric objectives such as the 6.5% unemployment
threshold that suggest the Fed will behave responsibly with respect to their
inflation target. In short, the Fed is trying hard to balance stable
long-term inflation expectations against the possibility of irresponsible
policy in the short-run. This is a difficult message to communicate.

Why is there so much anger and whining from the biggest winners in society?:

Plutocrats Feeling Persecuted, by Paul Krugman, Commentary, NY Times:
Robert Benmosche, the chief executive of the American International Group,
said something stupid the other day. And we should be glad, because his
comments help highlight an important but rarely discussed cost of extreme
income inequality — namely, the rise of a small but powerful group of what
can only be called sociopaths.

For those who don’t recall, A.I.G. is a giant insurance company that played
a crucial role in creating the global economic crisis... Five years ago,
U.S. authorities, fearing that A.I.G.’s collapse might destabilize the whole
financial system, stepped in with a huge bailout. ... For a time, A.I.G. was
essentially a ward of the federal government, which owned the bulk of its
stock, yet it continued paying large executive bonuses. There was,
understandably, much public furor.

So here’s what Mr. Benmosche did in an interview with The Wall Street
Journal: He compared the uproar over bonuses to lynchings in the Deep South
... and
declared that the bonus backlash was “just as bad and just as wrong.”
...

This is important. Sometimes the wealthy talk as if they were characters in
“Atlas Shrugged,” demanding nothing more from society than that the moochers
leave them alone. But these men were speaking for, not against,
redistribution — redistribution from the 99 percent to people like them.
This isn’t libertarianism; it’s a demand for special treatment. It’s not Ayn
Rand; it’s ancien régime. ...

The thing is, by and large, the wealthy have gotten their wish. Wall Street
was bailed out, while workers and homeowners weren’t. ...

So why the anger? Why the whining? And bear in mind that claims that the
wealthy are being persecuted aren’t just coming from a few loudmouths.
They’ve been all over the op-ed pages and were, in fact, a central theme of
the Romney campaign last year.

Well, I have a theory. When you have that much money, what is it you’re
trying to buy by making even more? You already have the multiple big houses,
the servants, the private jet. What you really want now is adulation; you
want the world to bow before your success. And so the thought that people in
the media, in Congress, and even in the White House are saying critical
things about people like you drives you wild.

It is, of course, incredibly petty. But money brings power, and thanks to
surging inequality, these petty people have a lot of money. So their
whining, their anger that they don’t receive universal deference, can have
real political consequences. Fear the wrath of the .01 percent!

Thursday, September 26, 2013

The New Normal? Slower R&D Spending: In case you need more to worry
about, try this: the pace of research and development (R&D) spending has
slowed. The National Science Foundation
defines R&D
as “creative work undertaken on a systematic basis in order to increase the
stock of knowledge” and application of this knowledge toward new
applications. ...

R&D spending is often cited as an
important source of productivity
growth within a firm, especially in terms of product innovation. But R&D
is also an inherently risky endeavor, since the outcome is quite uncertain.
So to the extent that economic
and policy uncertainty has helped make businesses more cautious in
recent years, a slow pace of R&D spending is not surprising. On top of that,
the federal funding of R&D activity remains under significant budget
pressure. See, for example, here.

So you can add R&D spending to the list of things that seem to be moving
more slowly than normal. Or should we think of it as normal?

Rising inequality and differential exposure to economic risk has caused
one group to see themselves as the “makers” in society who provide for the
rest and pay most of the bills, and the other group as “takers” who get all
the benefits. The upper strata wonders, “Why should we pay for social
insurance when we get little or none of the benefits?” and this leads to an
attack on these programs.

So he links the debt ceiling fight to the influence of the wealthy, who want
to dismantle the welfare state because it’s nothing to them, and they want lower
taxes. One could add that the very inequality that distances the rich from
ordinary concerns gives them increased power, and so makes their
anti-welfare-state views far more influential.

How, then, are things even worse than he says? Because many of the rich are
selective in their opposition to government helping the unlucky. They’re against
stuff like food stamps and unemployment benefits; but bailing out Wall Street?
Yay!

Seriously. Charlie Munger
says that we should “thank God” for the bailouts, but that ordinary people
fallen on hard times should “suck it in and cope.” AIG’s CEO — the CEO of a
bailed out firm! — says that complaints about bonuses to executives at such
firms are
just
as bad as lynchings (I am not making this up.)

The point is that the superrich have not gone Galt on us — not really, even
if they imagine they have. It’s much closer to pure class warfare, a defense of
the right of the privileged to keep and extend their privileges. It’s not Ayn
Rand, it’s Ancien Régime.

Resetting Expectations, by Tim Duy: Now that the smoke has cleared
somewhat, we see clearly that the taper will be pushed forward to some
data-dependent point in the future. But which point? That is tricky given
the Fed's predilection for focusing on the last employment reports when
setting policy. The Fed appears to want to shift away from asset purchases
in favor of forward guidance and is looking for the right time to begin that
process. Their modus operandi has been to see six months of good
employment data, send up a warning flag that the end of policy accommodation
is coming, and then back down when the data turns weaker in the next three
months.

If they continue that pattern, then we could be looking at mid-2014 before
enough evidence of sustainability emerges that the Fed feels confident they
can taper. But if they are on a knife edge now, they may only need two or
three months of good data to taper, assuming they see little risk that
interest rates will get away from them. Which gives a wide range for the
taper - no sooner sooner than December, as late as mid-2014 if the data
holds. But an end to asset purchases does not mean a solid recovery. The
Fed's expectation of a long period of low term rates suggests the healing
will remain anything but rapid.

Using this week's speech by New York Federal Reserve President
William Dudley as a baseline, consider his two tests for meeting the
requirement of "stronger and sustainable" labor market activity:

To begin to taper, I have two tests that must be passed: (1)
evidence that the labor market has shown improvement, and (2)
information about the economy’s forward momentum that makes me confident
that labor market improvement will continue in the future. So far,
I think we have made progress with respect to these metrics, but have
not yet achieved success.

On the first point, he notes that the unemployment rate overstates the
degree of labor market improvement:

Other metrics of labor market conditions, such as the hiring,
job-openings, job-finding rate, quits rate and the
vacancy-to-unemployment ratio, collectively indicate a much more modest
improvement in labor market conditions compared to that suggested by the
decline in the unemployment rate.

It is very unfortunate from a communications perspective that the Fed keeps
throwing out markers for the unemployment rate, first the 6.5% threshold for
interest rates and the 7% trigger for asset purchases. In the absence of
those makers, I think most of us would agree that healing in the labor
market is far from complete:

It appears pretty evident that the unemployment rate threshold is
essentially meaningless as long as inflation remains below 2%. Which seems
to imply that the Evans Rule really collapses to an inflation targeting
regime.

On the second point:

...fiscal uncertainties loom very large right now as Congress considers
the issues of funding the government and raising the debt limit ceiling.
Assuming no change in my assessment of the efficacy and costs associated
with the purchase program, I’d like to see economic news that makes me
more confident that we will see continued improvement in the labor
market. Then I would feel comfortable that the time had come to
cut the pace of asset purchases.

The fiscal front is coming to a head in the next few weeks - the drop dead
date for hitting the debt ceiling is October 17. So far, market
participants have been fairly relaxed about the entire spectacle. The
general belief is that, like in the past, the Republicans ultimately choose
not to commit political self-destruction and cave in the final hours. We
will see.

As far as the continued improvement in the labor markets, I find it curious
that the Fed seems to be fairly incapable of seeing through the ebb and flow
of the data to the underlying trend. In particular, the issue of seasonal
distortions is revisited by
Matthew O'Brien and
Matthew Klein, but you really don't need to know about the seasonal
effects to read this chart:

Too much focus on the last three months of this data is dangerous - this
data has a lot of monthly variability and is subject to significant
revisions. I don't think momentum has faded or surged. The economy
continues to grind forward at a disappointing pace. You can argue that
either the Fed needs to provide more accommodation, or that asset purchases
are not a particularly effective form of easing. The Fed is taking a middle
ground - saying QE is effective, but shifting to forward guidance which they
find to be more effective and more consistent with "normal" monetary policy.

Overall, although St. Louis Federal Reserve President
James Bullard described the meeting as a close call and said that
tapering could begin in October, it is virtually impossible for the data to
meet Dudley's requirements by that time. December would be the earliest,
and even that is pushing it.

With respect to forward guidance, the Federal Reserve is trying to push more
accommodation via expectations that rates remain low far, far into the
future. Back to Dudley:

In addition, it is worth explaining why we anticipate the federal funds
rate is still likely to be quite low relative to what Committee
participants consider normal over the longer run, even as the Committee
gets close to its employment and inflation objectives. For
example, in the September Summary of Economic Projections, the median
projection for the federal funds rate in the fourth quarter of 2016 is 2
percent, far below the median long-run federal funds rate projection of
4 percent, at the same time that the unemployment rate and inflation are
close to the Committee’s long-run objectives.

The Fed's unemployment projections:

Dudley's first explanation:

How does one explain this? As noted by Chairman Bernanke in last week’s
press conference, the still low federal funds rate projections for 2016
reflect the fact that economic headwinds—such as tight credit standards
and ongoing fiscal consolidation—are likely to take a long time to fully
abate. As a result, monetary policy will have to keep short-term
interest rates very low for a sustained period in order for the
Committee to achieve its objectives.

I think this implies that rates would need to rise quickly once those
objectives are reached, which makes 2017 interesting. Dudley's view
differs:

My view is that the neutral federal funds rate consistent with trend
growth is currently very low. That’s one reason why the economy is not
growing very fast despite the current accommodative stance of monetary
policy. Although the neutral rate should gradually normalize over
the long-run as economic fundamentals continue to improve and headwinds
abate, this process will likely take many years. In the meantime,
the federal funds rate level consistent with the Committee’s objectives
of maximum sustainable employment in the context of price stability will
likely be well below the long-run level.

This line of thought seems to have somewhat different implications. First,
rates do not need to rise quickly when full employment is reached. Second,
though, it somewhat begs the question of why the Fed is not pressing harder
to make policy more accommodative now to accelerate the pace of the
recovery. I think the answer is that they believe that they they are facing
the limits of monetary policy in the face of fiscal restraint.

The possibility of a very long period of low rates deserves some additional
attention from Fed speakers. It speaks to a period of stagnation which,
interestingly, is a road
Paul Krugman headed down today:

Our current episode of deleveraging will eventually end, which will
shift the IS curve back to the right. But if we have effective financial
regulation, as we should, it won’t shift all the way back to where it
was before the crisis. Or to put it in plainer English, during the good
old days demand was supported by an ever-growing burden of private debt,
which we neither can nor should expect to resume; as a result, demand is
going to be lower even once the crisis fades.

And here’s the worrisome thing: what if it turns out that we need
ever-growing debt to stay out of a liquidity trap?...

...This is not a new fear: worries about secular stagnation, about a
persistent shortfall of demand even at low interest rates, were very
widespread just after World War II. At the time, those fears proved
unfounded. But they weren’t irrational, and second time could be the
charm.

Bear in mind that interest rates were actually pretty low even during
the era of rising leverage, and got worryingly close to zero after the
2001 recession and even, you might say, after the 90-91 recession (there
was talk of a liquidity trap even then). It’s not hard to believe that
liquidity traps could become common, if not the norm, in an economy in
which prudential action, public and private, has brought the era of
rising leverage to an end.

Finally, I am a little concerned that forward guidance is being used only in
reaction to disappointing outcomes and not proactively to accelerate the
pace of improvement. Here I think the conditionality on the policy forecast
prevents the Fed from communicating an "irresponsible" policy path. An
upper bound of 2.5% on inflation is hardly irresponsible.

Bottom Line: Policy expectations have been reset; tapering is not expected
at the next meeting. December at the earliest, but even that is
questionable. The Fed is looking for an opportunity to transfer
accommodation from asset purchases to forward guidance. Somewhat stronger
data and obvious signs that bond market response would be muted would help
clear the way for tapering. The more we focus on the forward guidance, the
easier it will be for the Fed to taper. It is worth thinking about the
implications of the Fed's expectation of a very long period of low rates -
what it says about the economy and the limits of monetary policy.

It is important to get the distribution of wealth right, or as right as
you can, so that household willingness-to-pay properly represent social
marginal values.

It is important to get aggregate demand right--for the government to
create the right amount of safe and of liquid assets to match shifting
private sector demand and so make Say's Law true in practice if not in
theory--so that the problems economic policy is dealing with are Harberger
Triangles and not Okun Gaps.

Then you can let the competitive market rip--as long, that is, as...

You have also imposed the right Pigovian taxes and bounties to deal with
externalities.

"But the Coase Theorem" you say? The Coase Theorem is three things:

An injunction to carve property rights at the joints--to bundle powers,
rights, obligations so that you have to impose as little in the way of
Pigovian taxes and bodies as possible.

A powerful way of thinking about whether the proper Pigovian taxes and
bounties are best imposed through Article I processes (legislation) or
Article III processes (adjudication).

A thought experiment that, as Ronald Coase complained until the day he
died, was seized by George Stigler for his own purposes and is much more
often misinterpreted than applied.

The self-deluded who don't know what they're doing and the vested interests
that fear they would be impoverished when we to do the right thing dealing with
global warming are still holding on to their first line of defense: that global
warming is not happening. They have, however, built a second line of defense:
that global warming was happening until 1995, but then something stopped it, and
it will not resume. And behind that is the third line of defense that they are
now building which we are here to think about today: that we cannot afford to do
the right Pigovian tax-and-bounty thing, for dealing with global warming will
cost jobs and incomes.

This is the fifth policy-relevant case I have seen in recent years of the
political right that claims to love the market system denying and abandoning the
basic principles that underpin the technocrat judgment that the market system
can and often is a wonderful social economic calculation, allocation, and
distribution mechanism. It is almost as if their previous advocacy of the
technocratic case for the market system was simply a mask for their vested
interests. We have seen this in opposition to doing the right thing in financial
regulation; in the management of aggregate demand; in the provision of the right
level of social insurance in the long run; and in shifting the policy mix to
partially offset the medium-run rapid rise in inequality. Milton Friedman and
George Stigler always used to say that you were better off relying on market
contestability rather than capture of old regulatory bureaucracies like the
interstate commerce commission to deal with the market failures created by
private monopoly, but the problems like excessive inequality and poverty on the
one hand and pollution on the other required government action--a negative
income tax in the first case, and a market-based antipollution policy via
Pigovian taxes and bounties in the second. That is now, largely, out the window.

That's what I thought to myself when the economists at the Brookings
Institution's Panel on Economic Activity said only the "serious" ones would
stick around for the
last paper on seasonal adjustmentzzzzzzz...

... but a funny thing happened on the way to catching up on sleep. It turns
out seasonal adjustments are really interesting! They explain why, ever
since Lehmangeddon, the economy has looked like it's speeding up in the
winter and slowing down in the summer.

In other words, everything you've read about "Recovery
Winter" the past few winters has just been a statistical artifact of
naïve seasonal adjustments. Oops. ...

The BLS only looks at the past 3 years to figure out what a "typical"
September (or October or November, etc.) looks like. So, if there's, say, a
once-in-three-generations financial crisis in the fall, it could throw off
the seasonal adjustments for quite awhile. Which is, of course, exactly what
happened. ...

And that messed things up for years. Because the BLS's model thought the job
losses from the financial crisis were just from winter, it thought those
kind of job losses would happen every winter. And, like any good seasonal
model, it tried to smooth them out. So it added jobs it shouldn't have to
future winters to make up for what it expected would be big seasonal job
losses. And it subtracted jobs it shouldn't have from the summer to do so.
...

Now, the one bit of good news here is this effect has already faded away for
the most part. Remember, the BLS only looks back at the past 3 years of data
when it comes up with its seasonal adjustments -- so the Lehman panic has
fallen out of the sample.

Here are two words we should retire: Recovery Winter. It was never a thing.
The economy wasn't actually accelerating when the days got shorter, nor was
it decelerating when the days got longer. ... The BLS can, and should, do
better.

[T]he article ... resurrects the "Blame it on Beijing" view of the origins
of the crisis. As if all that capital flowing into America came out of
nowhere -- that housing boom, deregulation of financial markets, etc. had
nothing to do with actual deregulatory actions pushed by the Administration.
More on the "Blame it on Beijing" thesis
here and
here. (Heck, I got seemingly infinite numbers of offers for credit cards
in 2007, but I didn't take 'em all, borrow to the max, and then default.)
...

I agree that the measures undertaken in the immediate aftermath of Lehman
were extremely important, including the conservatorship of the GSEs, and
implementation of TARP. See the
discussion by Phill Swagel of crisis management during the height of
crisis.

But, Lazear and Hennessey blur the distinction between Fed actions and those
of the Administration. To say the Bush Administration ended the
crisis overstates the case (to say the least).

Finally, the entire article reminds me of the person who builds a house in
the middle of a big area of dry grass, lobbies against putting any
regulations that might require tile rooftop, goes on and puts on a wood
shingle rooftop, fails to clear away the dry brush surrounding the house,
and then -- when the house catches on fire -- claims victory when one room
is saved because a lawn hose was trained on that part of the house. ....

Two from Paul Krugman. The first echoes the point I make in
my column today about the attempt to use fear over the debt (and hence the need for austerity) as an excuse to
dismantle the welfare state:

What’s It All About Then: Simon Wren-Lewis writes with feeling about the
“austerity
deception“; what sets him off is a post that characterizes the whole
austerity debate as being about “big-state” versus “small-state” people.

Wren-Lewis’s point is that only one side of the debate saw it that way.
Opponents of austerity in a depressed economy opposed it because they
believed that this would worsen the depression — and they were right.

Proponents of austerity, however, were lying about their motives. Strong
words, but if you look at their recent reactions it becomes clear that all
the claims about expansionary austerity, 90 percent cliffs and all that were
just excuses for an agenda of dismantling the welfare state. ...

But I think growing inequality is a big driving force behind this effort.

And since I've complained in past columns that fiscal policy has not received enough attention (particularly how bad it's been), it's nice to see this:

But we’re clearly still well below potential. And we’ve also had exactly the
wrong fiscal policy given that reality plus the zero lower bound on interest
rates, with unprecedented austerity. So, how much of our depressed economy
can be explained by the bad fiscal policy?

To a first approximation, all of it. By that I mean that to have something
that would arguably look like full employment, at this point we wouldn’t
need a continuation of actual stimulus; all we’d need is for government
spending to have grown normally, instead of shrinking. ...[does calculations to show this]...

Monday, September 23, 2013

How Austerity Wrecked the American Economy, by Kevin Drum: With
Washington DC's attention focused on the antics of Ted Cruz and the tea
partiers, who are threatening to shut down the government unless Obamacare
is defunded, it's easy to lose sight of the bigger picture: Aside from
Obamacare, the budget battles of the past three years have been exclusively
about the Republican obsession with cutting spending while we're trying to
recover from the worst recession since World War II.

Government spending at all levels is far below the level of any other recent
recovery. Sixteen quarters after the end of the recession, spending during
past recoveries has been 7-15 percent higher than it was at the
start. This time it's 7 percent lower, despite the fact that the
2008-09 recession was the deepest of the bunch. Reagan, Clinton, and Bush
all benefited from rising spending during the economic recoveries on their
watches. Only Obama has been forced to manage a recovery while government
spending has plummeted.

And there's no end in sight. Ted Cruz will lose his battle to defund
Obamacare. But the tea partiers have already won their battle to cripple the
American economy and Obama's presidency with it.

Why do conservatives want to reduce funding for the food stamp program?:

Free to Be Hungry, by Paul Krugman, Commentary, NY Times:
...Conservatives ... have just voted to
cut sharply
... the food stamp program — or, to use its proper name, the Supplemental
Nutritional Assistance Program (SNAP)... Conservatives are deeply committed
to the view that the size of government has exploded under President Obama
but face the awkward fact that
public
employment is down sharply, while overall spending has been
falling fast as a share of G.D.P. SNAP, however, really has grown a
lot,... from 26 million Americans in 2007 to almost 48 million now.

Conservatives look at this and see what, to their great disappointment, they
can’t find elsewhere..., explosive growth in a government program. ...

The recent growth of SNAP has indeed been unusual, but then so have the
times... Multiple careful
economic
studies have shown that the economic downturn explains the great bulk of
the increase in food stamp use. And ... food stamps have at least mitigated
the hardship, keeping millions of Americans
out of poverty. ...

But, say the usual suspects, the recession ended in 2009. Why hasn’t
recovery brought the SNAP rolls down? The answer is, while ... the income of
the top 1 percent
rose 31 percent from 2009 to 2012,... the real income of the bottom 40
percent actually fell 6 percent. Why should food stamp usage have gone down?

Still, is SNAP..., as Paul Ryan ... puts it, an example of turning the
safety net into “a
hammock that lulls able-bodied people to lives of dependency and
complacency.”

One answer is,
some hammock: last year, average food stamp benefits were
$4.45 a day.
Also, about those “able-bodied people”: almost two-thirds of SNAP
beneficiaries are children, the elderly or the disabled, and most of the
rest are adults with children.

Beyond that, however, you might think that ensuring adequate nutrition for
children, which is a large part of what SNAP does, actually makes it less,
not more likely that those children will be poor and need public assistance
when they grow up. And that’s what the evidence shows. ...

SNAP, in short, is public policy at its best. ... So it tells you something
that conservatives have singled out this of all programs for special ire.

Even some conservative pundits worry that the war on food stamps, especially
combined with the vote to increase farm subsidies, is bad for the G.O.P.,
because it makes Republicans look like meanspirited class warriors. Indeed
it does. And that’s because they are.

Sunday, September 22, 2013

Lane Kenworthy and Timothy Smeeding issued this "Country Report for the
United States" on the impact of growing inequality. It's a relatively long
report with lots of tables and figures, but let me highlight one paragraph from
the executive summary:

Growing Inequalities and their Impacts in the United States, by Lane
Kenworthy Timothy Smeeding, Country Report for the United States: ... We
conclude that living standards in the middle of the distribution were and
are falling during the Great Recession . Moreover, with faint prospects of a
rapid recovery, the losses of the Great Recession increasingly mount. The
forecast is that unemployment will not return to 6.5 percent levels for
another three years or longer. While the trend in inequality i n the United
States has been ever upward, we believe that i t will be politically and
socially difficult for U.S. inequality to continue to grow at the top at the
expense of the collapsing middle class, the majority of whom believe ,
perhaps rightly so, that their children will be worse off economically than
they are. If so, we might expect some moderation in the growth of United
States inequality in the next decade.

I'm curious what you think about this. Are we on the verge of a populist
uprising that result in "some moderation in the growth of United States
inequality in the next decade," or will things continue along the present path
for quite some time?

The research offers the first insight into the processes in the brain that
underpin financial decisions and behavior leading to the formation of market
bubbles. ... Although bubbles have been intensely investigated in economics,
the reasons why they arise and crash are not well understood and we know
little about the biology of financial decision behavior.

Researchers at the California Institute of Technology ... found that the
formation of bubbles was linked to increased activity in an area of the
brain that processes value judgments. People who had greater brain activity
in this area were more likely to ride the bubble and lose money by paying
more for an asset than its fundamental worth.

In bubble markets, they also found a strong correlation between activity in
the value processing part of the brain and another area that is responsible
for computing social signals to infer the intentions of other people and
predict their behaviour.

Dr Benedetto De Martino, a researcher at Royal Holloway University of London
who led the study while at the California Institute of Technology, said: "We
find that in a bubble situation, people ... shift the brain processes
they're using to make financial decisions. They start trying to imagine how
the other traders will behave and this leads them to modify their judgment
of how valuable the asset is. They become less driven by explicit
information, like actual prices, and more focused on how they imagine the
market will change. ...

Professor Peter Bossaerts from the University of Utah, a co-author of the
study, explains: "It's group illusion. When participants see inconsistency
in the rate of transactions, they think that there are people who know
better operating in the marketplace and they make a game out of it. In
reality, however, there is nothing to be gained because nobody knows
better." ...

The findings give the first glimpse to the decision-making mechanisms in the
brain that drive financial markets. Although they may not help to predict
the onset of a bubble, the research could help to design better social and
financial interventions to avoid the formation of future bubbles in
financial markets.

Lehman Was Not Alone – Measuring System Risk in the 2008 Crisis, by Robert
Engle: On September 15, 2008, Lehman Brothers filed for bankruptcy and
ushered in the worst part of the recent financial crisis. Today, we still
discuss whether taxpayer money should have been used to rescue Lehman. My
colleagues at NYU and I have developed measures of systemic risk, and this
fifth anniversary affords us a good opportunity to look at what these
measures would have indicated to Treasury Secretary Paulsen if they had been
available at that time.

The answer is quite surprising. ... On the website, you can go back to August 29, 2008, to see the ranking of U.S.
firms based on SRISK. . Was Lehman at the top of the list in 2008? No. In
fact, it was Number 11. ...

Saturday, September 21, 2013

... In a paper published
last month in Science, with Profs. Anandi Mani at the University of
Warwick and Jiaying Zhao at the University of British Columbia,
Professor Shafir and I waded into politically charged territory. Some
people argue that the poor make terrible choices and do so because they
are inherently less capable. But our analysis of scarcity suggests a
different perspective: perhaps the poor are just as capable as everyone
else. Perhaps the problem is not poor people but the mental strain that
poverty imposes on anyone who must endure it. ...

The food stamps program: In an ideal policy world, would food stamps
exist as a program separate from cash transfers? Probably not. But as it
stands today, they are still one of the more efficient programs of the
welfare state and the means-testing seems to work relatively well. And
giving people food stamps — since almost everyone buys food — is almost as
flexible as giving them cash. It doesn’t make sense to go after food stamps,
and you can read the recent GOP push here as a sign of weakness, namely that
they, beyond upholding the sequester, are unwilling to tackle the more
important and more wasteful targets...

Loss of economic exceptionalism, by Claude Fischer: One of the key
dimensions of “American Exceptionalism” is the idea that America is the land
of opportunity more than any other. We would like to believe that American
children who are raised in the meanest conditions are likelier to move up in
the world than are children elsewhere. Yet, as of today, the U.S. does not
provide more upward mobility than other nations do; if anything, young
Americans’ economic fortunes are more tied to those of their parents than is
true in other western nations. So, where did this image of exceptional
mobility come from?

Two economists, Jason Long and Joseph Ferrie, published a
study this summer in
the American Economic Review that creatively brings together some
19th-century data to argue that there was a time when the U.S. was
exceptionally open – or, at least, more open than Britain was. Two pairs of
sociologists wrote critical comments on the study (here
and here). Yet, even
with the controversy, there is a lesson to be learned. ...[discusses
controversy]...

But it is fair to conclude – at least, I do – that in the 21st century, the
U.S. no longer has an exceptionally open and mobile economy. That may be so
because the class system has gotten more rigid here or because it has gotten
less rigid elsewhere in the West, or both. In any case, the lesson is that
our ideology of being the exceptional land of opportunity is a hangover from
a time when it was true – but is no more.

Friday, September 20, 2013

Manage the macroeconomy to match aggregate demand to potential supply. Take the
dual mandate seriously: maintaining full employment is as important a central
bank goal as low and stable inflation--and much more important than preserving
healthy margins for the banking sector. Run large deficits--run up the national
debt--in times of war, depression, or other national emergency calling for
government action. Pay down the debt in other times.

Invest. Invest in ideas, in equipment capital, in structures capital, in
education: we need more of all forms of investment. Boost public and private
investment: we need both kinds.

Over the past generation, America has shifted enormous resources into value-subtracting
industries: health-care administration, prisons, finance, carbon energy. We need
to reverse those shifts, and focus the American economy on the value-creating
sectors rather than the value-subtracting ones.

We ought to have had a carbon tax 20 years ago. We still need one.

We need more immigration. It is much easier, worldwide, to move the people to
where the institutions are already good than to make good institutions where the
people are. More immigration produces a richer country for those already here.
More immigration is a mitzvah for immigrants. More immigration is, to a a lesser
degree, a mitzvah for those in poor countries outside who see less population
pressure on resources. And a U.S. in 2070 that has 600 million people is more of
an international superpower than a U.S. in 2070 that has only 400 million
people.

We need more equality. If we want to have equality of opportunity 50 years from
now, we need substantial equality of result right now.

We are going to need a bigger and better government. The private unregulated
market does not do well at health-care finance, at pensions, or at education
finance. The private unregulated market does not do well at research and
early-stage development. The private unregulated market does not do well with
commodities that are non-rival. We are moving into a twenty-first century in
which these sectors will all be larger slices of what we do, and so a
well-functioning economy will need a larger government relative to the private
economy than the twentieth century did.

I'd add that we need a more balanced representation of interests in the political arena. As it stands, the deck is stacked against the middle class and that leads to economic distortions that work in favor of the privileged class (and come at the expense of the broader economy).

It helps, I think, to understand just how unprecedented today’s political
climate really is.

Divided government in itself isn’t unusual and is, in fact, more common
than not. Since World War II, there have been 35 Congresses, and in only 13
of those cases did the president’s party fully control the legislature.

Nonetheless, the United States government continued to function. ... Nobody
even considered the possibility that a party might try to achieve its
agenda, not through the constitutional process, but through blackmail — by
threatening to bring the federal government, and maybe the whole economy, to
its knees unless its demands were met.

True, there was the government shutdown of 1995. But this was widely
recognized after the fact as both an outrage and a mistake. ...

Yet, at the moment, it seems highly likely that the Republican Party will
refuse to fund the government, forcing a shutdown at the beginning of next
month, unless President Obama dismantles the health reform that is the
signature achievement of his presidency. Republican leaders realize that
this is a bad idea...

How did we get here? ...

First came the southern strategy, in which the Republican elite cynically
exploited racial backlash to promote economic goals, mainly low taxes for
rich people and deregulation. Over time, this gradually morphed into what we
might call the crazy strategy, in which the elite turned to exploiting the
paranoia that has always been a factor in American politics — Hillary killed
Vince Foster! Obama was born in Kenya! Death panels! — to promote the same
goals.

But now we’re in a third stage, where the elite has lost control of the
Frankenstein-like monster it created.

So now we get to witness the hilarious spectacle of
Karl Rove in The Wall Street Journal, pleading with Republicans to
recognize the reality that Obamacare can’t be defunded. Why hilarious?
Because Mr. Rove and his colleagues have spent decades trying to ensure that
the Republican base lives in an alternate reality defined by Rush Limbaugh
and Fox News. Can we say “hoist with their own petard”?

Of course, the coming confrontations are likely to damage America as a
whole, not just the Republican brand. But, you know, this political moment
of truth was going to happen sooner or later. We might as well have it now.

Thursday, September 19, 2013

Does competition get rid of waste in the private sector?: It is very
common to hear comments about the waste of resources when referring to
governments and the public sector.
Paul Krugman does his best to argue against this popular view by showing
that most of what government do is related to services that we demand and
value as a society (it is not about hiring civil servants that produce no
useful service). As he puts it, the government is an "insurance company with
an army". But critics will argue that even if this is the case, the
functioning of that (public) insurance company is extremely inefficient. In
fact, we all have our list of anecdotes on how governments waste resources,
build bridges to nowhere and how politicians are driven by their own
interest, their ambitions or even worse pure corruption. If only we could
bring the private sector to manage these services!

In addition to the anecdotal evidence there is something else that matters:
we tend to use framework that starts with the assumption that in the private
sector competition will get rid of waste. An inefficient company will be
driven out of business by an efficient one. An inefficient and corrupt
manager will be replaced by one who can get the work done. And we believe
that the same does not apply to governments (yes, there are elections but
they do not happen often enough plus there is no real competition there).

But is competition good enough to get rid of all the waste and
inefficiencies in the private sector? I am sure there are many instances
where this is the case but I am afraid there are also plenty of cases where
competition is not strong enough. And just to be clear, I am not simply
talking about large companies that abuse monopoly power, I am thinking of
all the instances where the competitive threat is not enough to eliminate
inefficiencies. ...

He goes on to give two examples of private sector waste and inefficiency resulting from insufficient competetive forces, the large amount of waste, destruction, and inefficiency caused by the financial crisis and the large amount of waste in private sector healthcare markets (he shows one estimate that excess costs are 31% of total spending on health care). He concludes with:

But ...[when it comes to].. waste in other sectors, we simply do not know about
it, we do not even attempt to measure it (at least at the macro level). And the
reason why we do not bother measuring it is because we assume that markets and
competition must make this number close enough to zero. Maybe it is time to
challenge this assumption.

Further Post-Mortem, by Tim Duy: Federal Reserve Chairman Ben Bernanke took
many of us to the woodshed today with the unexpected decision to delay tapering
until a later date. I am still processing the outcome of the FOMC meeting, and
I suspect I will still be processing it a week from now. At the moment, I am
wary of overreacting to this meeting, fearing the possibility of being slapped
around again at the next meeting. So for the moment I am going to put aside the
explanation that the Fed wanted "to send a message" to markets about who
dictates monetary policy. Same to for the idea the Fed' s reaction curve has
shift measurably. Instead, I think it best to keep it simple - the Fed decided
they didn't have enough evidence to expect the current momentum, such as it is,
would be sustained and consequently decided to hold pat.

Danny Vivik presents
his take of this story, concluding that most analysts did not take a
sufficiently literal view of the June FOMC statement:

The Fed also upgraded
its economic forecasts and in the press conference, Bernanke repeatedly
emphasized the improvement in the labor market...Interest rates on the
10-year Treasury note skyrocketed while
stocks and gold both fell. The market took it all to mean that easy money
was coming to an end soon...Except that wasn’t what Bernanke or the Fed was
trying to say. They were trying to say that if economic data continues
to come in positively, then the Fed will scale back its bond-buying
program. But only if the economic data is good.

Vivik concludes that the data did not come in positively, and thus we should
not have expected tapering in the first place. I think there is a risk in
underestimating the Fed's tapering resolve in adopting that view. It depends, I
think, in how you interpret this section of the FOMC statement:

Taking into account the extent of federal fiscal retrenchment, the
Committee sees the improvement in economic activity and labor market
conditions since it began its asset purchase program a year ago as
consistent with growing underlying strength in the broader economy. However,
the Committee decided to await more evidence that progress will be sustained
before adjusting the pace of its purchases.

I think this means that, in general, the data was broadly consistent with the
Fed's expectations. That is, we weren't reading the data wrong. They just
decided that they could wait until longer before initiating the taper. And why
might they want to do so? Two reasons:

Household spending and business fixed investment advanced, and the
housing sector has been strengthening, but mortgage rates have risen further
and fiscal policy is restraining economic growth.

The fiscal policy issue is significant. Indeed, it has always somewhat of a
mystery why the Fed opened up the possibility of a tapering in September given
that there is no way they would have sufficient data to fully assess the impact
of fiscal contraction. They seemed to have been content that the private sector
was grinding forward despite the contraction. What's different today? It may be
simply that this issue suddenly became more important in the last week as the
Republican party increasingly looks to
be willing to commit political suicide over the Obamacare issue, and willing
to take the economy with them. But it also might be the realization that with
inflation still low, there is no rush to taper given fiscal policy uncertainty
regardless of the budget/debt debate in Congress.

The higher mortgage rates, and related financial tightening, are also at
play. But I think we can be excused to a certain extent for dismissing this as
a relevant issue prior to this meeting. Policy makers did not seem to be
particularly concerned about the increase in rates until today. Indeed,
Bernanke in his press conference today argued that higher rates both removed
froth from the market and reflected expectations of stronger growth.

The latter explanation, however, is challenged by the Fed's small downgrade
to the GDP forecast. Overall, the forecast has not changed dramatically.
Instead, the proximate cause of higher rates was the growing chatter of
tapering in the Spring culminating with Bernanke's press conference in June. In
short, just talking about tapering was tightening, and that tightening thus
eliminated the need by immediate tapering. But then if rates ease back, will
the Fed will turn its attention back toward tapering? Nice little circle the
Fed has trapped itself in, no?

Worse yet, the Fed, or at least Bernanke, does not want to assume any
culpability for that tightening. He seemed to imply that it wasn't his
communication policy that was wrong, it was just our listening ability that was
a problem. On this, I find myself siding with
Justin Wolfers:

This whole taper debate is one that should never have happened. It’s the
result of a failed communication strategy.

I am willing to accept that analysts, including myself, didn't sufficiently
take the fiscal story or higher rates into account when divining this meeting,
although I think the Fed lulled us into submission on the latter issue. But
really, if the Fed is being transparent with its communication strategy, should
every other meeting result in a 15bp move in Treasuries? Bernanke's "it's not
me, it's you" story falls a little flat, in my opinion. They are clearly
muddling their message.

In short, it seems that if the Fed now sees higher interest rates rates as
undermining their forecast, they need to recognize that they dropped the ball;
talk of tapering was clearly premature. We thought is was a data dependent
policy and the tapering talk began long before any data suggested it was
necessary. Once again speaks to their bias against quantitative easing. They
want out of the program, but are finding it to be a roach motel.

Finally, notice the increasing challenges surrounding the thresholds,
particularly the unemployment rate. Bernanke backed off his 7% threshold today
for tapering, but he almost had to with that number staring him in the face.
And interestingly they held their unemployment forecasts steady even though the
unemployment rate has been steadily dropping and is already in their end-of-year
average range. The problem, I suspect, is that it is hard to maintain a dovish
message given falling unemployment rates in the context of the thresholds. The
problem is made worse because they can't decide if falling unemployment rates
reflect real improvement in the labor market or cyclical decline in labor force
participation. So at this point the unemployment threshold look to be defunct.
They need a new, meaningful threshold. Or will the Fed use unemployment when
they support the story they want to tell, and put it away when it is
inconvenient. It is certainly going to be a communications challenge when you
base policy on a variable you don't really understand.

Bottom Line: I am wary about reading too much into today's event, fearful
that the next batch of Fed speakers is going to emphasize that they are very
close to tapering. I will be chewing on this one for some time. Bur for now,
if the Fed is staying true to their data story, the six weeks between now and
the October meeting look to be too short to fully evaluate the impact of fiscal
contraction and higher rates. December looks like the earliest date now, which
puts the initial tapering in line with what I think would have been the
consensus view had not the FOMC accelerated expectations of tapering earlier
this year.

Wednesday, September 18, 2013

No Taper - Yet, by Tim Duy: The FOMC pulled yet another rabbit out of the
hat by holding off on the expected taper, slamming down on analysts (including
yours truly) who thought the Fed would pull the trigger today. Two significant
factors that held the FOMC in check were fiscal policy and higher interest
rates. From the statement:

Household spending and business fixed investment advanced, and the
housing sector has been strengthening, but mortgage rates have risen further
and fiscal policy is restraining economic growth...

...Taking into account the extent of federal fiscal retrenchment, the
Committee sees the improvement in economic activity and labor market
conditions since it began its asset purchase program a year ago as
consistent with growing underlying strength in the broader economy. The
Committee sees the downside risks to the outlook for the economy and the
labor market as having diminished, on net, since last fall, but the
tightening of financial conditions observed in recent months, if sustained,
could slow the pace of improvement in the economy and labor market.

Now, why did financial conditions tighten? Oh yes, I recall - because just
talking about tapering is the same as tightening. Remember, unless yields head
much lower (they are down around 10bp as I write), much of the damage is already
done is already done.

Holding off on tapering also achieves two other objectives. The first is to
make clear that policy is data dependent:

However, the Committee decided to await more evidence that progress will
be sustained before adjusting the pace of its purchases....Asset purchases
are not on a preset course, and the Committee's decisions about their pace
will remain contingent on the Committee's economic outlook as well as its
assessment of the likely efficacy and costs of such purchases.

The second - assuming we now have an Octaber to look forward to - is that the
Fed can prove it can change policy in meetings not followed by a press
conference.

The downside is that there has been a clear communication failure on the part
of the Federal Reserve, and this should not be overlooked in the hysteria that
will surround this announcement. If they are concerned about the impact of
higher rates now, the Fed should have worried a little bit more about the impact
of talking about tapering two months ago. They should have pushed back harder
as the growing expectations for a change in policy. The data never really
supported tapering; I think we were mostly tripping over ourselves (again,
myself included) to justify the path toward tapering because Federal Reserve
speakers were giving little reason to think otherwise.

UPDATE: One take away from the press conference is that Bernanke thinks
markets have a listening problem at least as much as I tend to think he has a
communications policy. Fair enough.

Bottom Line: The Fed held steady - ultimately, the data appears to have won.
Unfortunately, if the Fed is now concerned about the impact of higher rates,
the economy already lost when Bernanke opened the tapering door wide open back
in June.

I was supposed to be on Reuters right now discussing the Fed decision, but
had technical problems (no sound). Grrr.

I was going to give four reasons for the delay.

But let me say first that I agree with the decision -- as I said yesterday, I
didn't think it was time to begin backing off of QE just yet. But I thought that
all of the talk about tapering and the predictions of $5-$20 billion change, and
the fact that financial markets were expecting something would tip the scales
toward beginning the taper.

Here's why I think they delayed:

1. Fiscal policy. The uncertainty over a government shutdown, how much
additional austerity there might be, and so on made the Fed nervous about doing
anything that might add to the negative shock from fiscal policy. Fiscal
policymakers have performed terribly over the course of the crisis, and the Fed
is the only game in town. It can't take the risk of adding to the potential
problems that fiscal policy might cause.

2. Inflation and unemployment. As I said already, inflation is too low and
unemployment is too high. There are no signs of an acceleration in the recovery
of unemployment, and no signs that inflation expectations are moving above the
Fed's long-run target. Since all signs point to easing, why do anything that
might be construed as a negative shock?

3. The Fed is gun shy. The negative shock -- i.e. the rise in long-term
interest rates and the corresponding slowdown in housing and investment -- when
it first began talking about tapering surprised the Fed. Just talking about
tapering led to an unexpected spike in interest rates and although it appears
that tapering was priced into financial markets, why risk another surprise? I
don't think additional bond purchases are going to do much good for the economy,
all that can be done has pretty much been done already, but there is the
potential for a negative reaction from markets and with all the less than robust
recovery, fiscal policy worries and the like, why take a chance?

4. Capital flight from developing markets. A investors have anticipated
rising yields do to the Fed potentially beginning to unwind policy, capital has
flowed from developing markets to the US causing problems for these countries.
Those problems could feed back into US markets and make a slow recovery even
slower, so why take that chance?

Overall, then, while there probably isn't a lot to be gained from continuing
QE, there is potentially a lot to lose from miscalculating the markets reaction
to the onset of tapering, and the Fed wants to be more sure than it is right now
about the strength of the economy before it takes that chance.

I had more to say, e.g. there's an argument to be made that this represents further easing (the rise in long-term rates has slowed mortgage markets, so the Fed is now buying a larger share of the assets issued in these markets, and the same is true for Treasuries -- due to the fall in the deficit and corresponding fall in new debt issues) but I'll leave it that for the moment. Here's the press release:

Press Release, Release Date: September 18, 2013, For immediate release:
Information received since the Federal Open Market Committee met in July
suggests that economic activity has been expanding at a moderate pace. Some
indicators of labor market conditions have shown further improvement in
recent months, but the unemployment rate remains elevated. Household
spending and business fixed investment advanced, and the housing sector has
been strengthening, but mortgage rates have risen further and fiscal policy
is restraining economic growth. Apart from fluctuations due to changes in
energy prices, inflation has been running below the Committee's longer-run
objective, but longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum
employment and price stability. The Committee expects that, with appropriate
policy accommodation, economic growth will pick up from its recent pace and
the unemployment rate will gradually decline toward levels the Committee
judges consistent with its dual mandate. The Committee sees the downside
risks to the outlook for the economy and the labor market as having
diminished, on net, since last fall, but the tightening of financial
conditions observed in recent months, if sustained, could slow the pace of
improvement in the economy and labor market. The Committee recognizes that
inflation persistently below its 2 percent objective could pose risks to
economic performance, but it anticipates that inflation will move back
toward its objective over the medium term.

Taking into account the extent of federal fiscal retrenchment, the Committee
sees the improvement in economic activity and labor market conditions since
it began its asset purchase program a year ago as consistent with growing
underlying strength in the broader economy. However, the Committee decided
to await more evidence that progress will be sustained before adjusting the
pace of its purchases. Accordingly, the Committee decided to continue
purchasing additional agency mortgage-backed securities at a pace of $40
billion per month and longer-term Treasury securities at a pace of $45
billion per month. The Committee is maintaining its existing policy of
reinvesting principal payments from its holdings of agency debt and agency
mortgage-backed securities in agency mortgage-backed securities and of
rolling over maturing Treasury securities at auction. Taken together, these
actions should maintain downward pressure on longer-term interest rates,
support mortgage markets, and help to make broader financial conditions more
accommodative, which in turn should promote a stronger economic recovery and
help to ensure that inflation, over time, is at the rate most consistent
with the Committee's dual mandate.

The Committee will closely monitor incoming information on economic and
financial developments in coming months and will continue its purchases of
Treasury and agency mortgage-backed securities, and employ its other policy
tools as appropriate, until the outlook for the labor market has improved
substantially in a context of price stability. In judging when to moderate
the pace of asset purchases, the Committee will, at its coming meetings,
assess whether incoming information continues to support the Committee's
expectation of ongoing improvement in labor market conditions and inflation
moving back toward its longer-run objective. Asset purchases are not on a
preset course, and the Committee's decisions about their pace will remain
contingent on the Committee's economic outlook as well as its assessment of
the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability,
the Committee today reaffirmed its view that a highly accommodative stance
of monetary policy will remain appropriate for a considerable time after the
asset purchase program ends and the economic recovery strengthens. In
particular, the Committee decided to keep the target range for the federal
funds rate at 0 to 1/4 percent and currently anticipates that this
exceptionally low range for the federal funds rate will be appropriate at
least as long as the unemployment rate remains above 6-1/2 percent,
inflation between one and two years ahead is projected to be no more than a
half percentage point above the Committee's 2 percent longer-run goal, and
longer-term inflation expectations continue to be well anchored. In
determining how long to maintain a highly accommodative stance of monetary
policy, the Committee will also consider other information, including
additional measures of labor market conditions, indicators of inflation
pressures and inflation expectations, and readings on financial
developments. When the Committee decides to begin to remove policy
accommodation, it will take a balanced approach consistent with its
longer-run goals of maximum employment and inflation of 2 percent.

Finding his own way: Ronald Coase (1910-2013), by Steven Medema, Vox EU:
Ronald Coase’s contributions to economics were much broader than most
economists recognize. His work was characterized by a rejection of
‘blackboard economics’ in favor of detailed case studies and a comparative
analysis of real-world institutions. This column argues that the ‘Coase
theorem’ as commonly understood is in fact antithetical to Coase’s approach
to economics.

...

Against ‘blackboard economics’

Coase’s criticisms of the theory of economic policy were part of a larger
critique of what he often referred to as ‘blackboard economics’ – an
economics where curves are shifted and equations are manipulated, with
little attention to the correspondence between the theory and the real
world, or to the institutions that might bear on the analysis. A similar set
of concerns led to his skepticism about the application of economic analysis
beyond its traditional boundaries. Contrary to popular misperception, Coase
had precious little interest in the economic analysis of law. Instead,
Coase’s ‘law and economics’ was concerned with how law affected the
functioning of the economic system.

It is ironic, then, that the idea most closely associated with Coase, the ‘Coase
theorem’, is in many respects the height of ‘blackboard economics’ and a
cornerstone of the economic analysis of law. Being misunderstood was
something of a hallmark of Coase’s career, as he pointed out on any number
of occasions. We should all be so fortunate.

Lehman was a systemically-important financial institution, and it was
foreseeable that an uncontrolled bankruptcy would be a disaster--the only
surprise was that it turned out to be a much bigger disaster than Paulson,
Bernanke, Geithner were expecting at the time.

There is a date--April 15, 2008, say--at which Lehman Brothers was "solvent"
in the sense that the Bush Treasury and the Bernanke-Geithner Fed would have
been willing to lend to it massively as they near-extinguished the claims of
its equity holders, closed down the institution, and distributed some of its
risk to the Federal Reserve and some of its risk to other financial
institutions.

There was a date--September 15, 2008--at which the Bush Treasury and the
Bernanke-Geithner Fed were unwilling to do that, and let Lehman go.

By continuity, in between there is a last date at which Lehman can still be
resolved in an orderly fashion--a date on which their special assistants
walk into Paulson's, Bernanke's, and Geithner's offices, and say: "Today may
be our last chance to close down Lehman in an orderly fashion. If things go
badly for Lehman on the markets today, by tomorrow it will be so clearly
insolvent that we will not be able to lend to it to grease its shutdown."

When Paulson, Bernanke, and Geithner heard that, they should immediately
have huddled, and then called Lehman and said: "You need to do a deal today,
because tonight we are going to announce that our judgment is that you are
on the edge of insolvency."

The evidence points to "yes". The president's economic initiatives – food
stamps, manufacturing, infrastructure, raising the debt ceiling, appointing
a new chairman of the Federal Reserve – have mostly ended in either neglect
or shambles. After five years, the Obama Administration's stated intentions
to improve the fortunes of the middle class, boost manufacturing, reduce
income inequality, and promote the recovery of the economy have come up
severely short.

Despite this, the president believes he is negotiating his economic agenda
with Congress from a position of strength, and almost every speech includes
some self-congratulatory note about how far the economy has come. ...

The president could not be more wrong or misleading in the way in which he
presents our economic progress. One can perfectly understand
economist Dean Baker's horror when he realized, back in August, that
Obama's economic team believes it is doing a good job.

It's time to end the delusion that this White House has accomplished even a
fraction of what it should be doing to help the economy. It should have been
focusing all its efforts on employment, perhaps by boosting job-retraining
programs, providing tax incentives for employers or supporting a
comprehensive infrastructure effort. Instead, the administration is falling
victim to political distractions and lack of follow-through and wasting its
meager political capital on the wrong fights.

The latest example is the debacle around Larry Summers. ...

To shut out the opposition to Summers, the president had to have been
wearing earplugs. How closed is his economic circle? How well do they fit
the profile of honest brokers about our economic situation? Loyalty is a
great thing. But that kind of trust is clearly not working for Obama. Maybe
he should stop relying on those he knows, and rely instead on those who know
what they're doing.

Gridlock in Congress is real, and legislation involving additional fiscal
policy measures or job creation would be difficult or impossible. But part of
that is due to the administration's failure to lead the conversation, to hammer
home at every opportunity how Congress is failing the middle class. The charge
that the administration is guilty of "political distractions and lack of
follow-through and wasting its meager political capital on the wrong fights" is
accurate in my view, particularly the lack of follow through. How many times has
the president announced some major effort at job creation, and that's the last
we hear about it? I don't think people understand how awful Congress has been where fiscal policy is concerned. I suppose the administration is worried about being blamed for the poor economy, so instead it talks about "how far the economy has come" due to its policies. But why not just tell the truth? Why not point at Congress and call for job creation through infrastructure construction at every opportunity, and let people know that Congress is to blame if it doesn't happen? Yes, the other side will try to blame the administration is if admits the economy is doing poorly, but that will happen anyway and it's a debate the administration ought to be able to win.

This graph shows the year-over-year change for ... four key measures of
inflation. On a year-over-year basis, the median CPI rose 2.1%, the
trimmed-mean CPI rose 1.7%, the CPI rose 1.5%, and the CPI less food and
energy rose 1.8%. Core PCE is for July and increased just 1.2%
year-over-year.

On a monthly basis, median CPI was at 2.1% annualized, trimmed-mean CPI was
at 1.5% annualized, and core CPI increased 1.5% annualized. Also core PCE
for July increased 0.9% annualized.

These measures indicate inflation is below the Fed's target.

Unemployment is too high and inflation is too low (and inflation expectations
are stable). Why are we talking about tapering?

Nah, the most depressing result comes when you look at the longer view of
household incomes in the United States. ...

Headlines about these numbers tend to focus on how we have now experienced a
lost decade for the middle-class American family... But ... it's really
worse than that.

In 1989, the median American household made $51,681 in current dollars (the
2012 number ... was $51,017). That means that 24 years ago, a middle class
American family was making more than the a middle class family was making
one year ago.

This isn't a lost decade for economic gains for Americans. It is a lost
generation.